Farr: Beware of Bond Funds and Especially These

One of the most confounding things about today's investment landscape is the fact that, following a 30-year bull market in bonds, retail investors continue to favor bonds over stocks.

According to data provider EPFR Global, $1.1 trillion has flowed into bond funds since the beginning of 2008, with $395 billion coming in this year alone.

This should be surprising given the very low yields available on bonds right now. At slightly over 1.6%, the yield on the 10-year Treasury bond is now very close to its all-time low. (Track Bonds Here)

The federal government will run its fourth straight trillion-dollar-plus deficit this year, yet there is no decrease in the insatiable demand for US Treasury bonds. If it seems unusual to you that the federal government should be able to continue borrowing more and more at lower and lower rates, you are not alone. (Read More:Fixed income market outlook.)

Eventually, there is likely to be a day of reckoning.

One of two things is likely to happen, and they are both bad for bond investors. The first is that investors will eventually reassess the credit risk inherent to "risk-free" US Treasuries. Harvard economists Carmen Reinhart and Ken Rogoff call this the "BANG" moment because the loss in confidence is sudden and unpredictable. This scenario is most likely to unfold if Congress is unable to successfully address the problem of long-term structural deficits caused by entitlement spending (Social Security and Medicare). If this indeed happens, yields on bonds of all stripes are likely to increase suddenly and dramatically as the Chinese central bank and other key investors decide they are tired of funding our profligate spending.

The second possibility is that the aggressive monetary policy employed by central banks across the world will eventually lead to sharp inflationary pressures.

We have all heard about this possibility as the major risk associated with aggressive Fed monetary easing. To date, inflation has remained in check thanks largely to high rates of unemployment and low rates of factory utilization. However, Fed "hawks" believe the central bank must remain vigilant as inflationary pressures could materialize rather abruptly. Under this scenario, interest rates will rise sharply as well.

Given that higher interest rates lead to lower bond prices, either of these scenarios could prove disastrous to bond investors. This is especially true for investors in bonds of long duration as these bonds are more sensitive to changes in interest rates. But it should be noted that bond investors may be at risk even if we avoid the two scenarios described above. If, for instance, the economy were to undergo a normal recovery and return to normalized rates of growth, interest rates will rise as they usually do during periods of economic recovery. Under this more benign scenario, bond investors could still be at risk.

Outside of the aforementioned risks in owning bonds right now, there are additional risks in owning bond mutual funds.

These darlings of the retail investing world have indeed produced strong returns over the past few years as interest rates have continued to fall. But what will happen if/when interest rates begin to rise? First, the fund losses will likely unnerve the fund's investors, causing some initial selling by fund shareholders. The selling of fund shares, in turn, will force fund managers to sell individual bond holdings into a declining market. These forced sales can lead to large price discounts and further forced selling. It is easy to see how a vicious cycle could lead to something much more serious than a minor correction.

But there is something more subtle to point out with funds that invest in municipal bonds.Unlike taxable bond funds that generally receive new money each month as 401K plan participants contribute with their monthly pay checks, municipal bond funds only get new money when investors make a decision to buy the fund. This makes the aforementioned scenario of forced selling particularly dangerous for municipal bond fund investors. They do not have the luxury of monthly cash infusions to cover redemptions. Moreover, given that individual investors represent most, if not all of the shareholders in a municipal bond fund, an unpleasant scenario could unfold whereby demand dries up altogether. Fund managers would be forced to sell bonds into a market that is dominated by the very group that initiated the selling to begin with.

In a nutshell, we feel strongly that there is, at the very least, a disconnect between what investors are expecting from bond fund ownership (particularly municipal bond funds) and what is an increasingly likely outcome.

DISCLOSURE: Given the challenging environment, we at Farr, Miller & Washington have taken a cautious approach to bonds over the past couple of years. We are investing with the understanding that bond yields are not very attractive right now and that rates could rise over the next couple of years. Therefore, we have kept our maturities relatively short so that we are able to take advantage of higher rates in the future. Furthermore, Farr, Miller & Washington manages each client account separately. Each client owns individual municipal bonds and not shares in a municipal bond fund. While client bond holdings may encounter price volatility under the scenarios described above, these positions will not be subject to forced selling.

Occasionally bond funds will transfer to us, and because of a low cost basis or other personal preference, we will be asked to hold them. Bond funds are also sometimes preferable to individual bonds in smaller accounts where diversification is an issue. Our clear preference and advice favors individual bonds. Individual bond holders such as our clients can choose to hold their bonds until maturity at which point they will assumedly receive full par value. Owners of shares in municipal bond funds, by contrast, may not have this luxury due to the market dislocations described above.

Michael K. Farr is President and majority owner of Farr, Miller & Washington, LLC. He is Chairman of the Investment Committee and is responsible for overseeing the day to day activities of the firm. Prior to starting FM&W, he was a Principal with Alex Brown & Sons.

Mr. Farr is a paid Contributor for CNBC television and has appeared on numerous broadcasts and has been quoted in global publications. He is a member of the Economic Club of Washington, DC, National Association for Business Economics, The World Presidents' Organization, and The Washington Association of Money Managers. He is the author of "A Million Is Not Enough," and "The Arrogance Cycle."